Larry McDonald: Four years after Lehman, financial regulation is still being ignored

As we approach the four-year anniversary of Lehman Brothers’ collapse, the current administration has done little to reduce the systemic risk inherent in our financial system, according to market commentary from Larry McDonald, senior director for credit, sales and trading at Newedge, and the author of “A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers.”

McDonald notes that, over the past 50 years, the country has seen a pattern of escalating financial crises that arrive every decade, each one worse than the last. At the time of Lehman’s collapse, he says, the size of the global stock market was estimated at $36.6 trillion — today, the size of the derivatives market has been pegged at $791 trillion. According to McDonald, this growth, combined with the shrinking number of U.S. banks, has created an untenable situation: “The stakes are just too high in 2012 not to attack this problem with precision solutions.”

Unfortunately, he says, the U.S. government has not been forthcoming with such solutions. Instead, the government’s “giant bureaucratic silos” fail to share information with each other, and the evolution of modern financial products continues to outstrip regulatory efforts. Notably, McDonald is skeptical that recent measures such as the Dodd-Frank Act will be useful when dealing with “too big to fail” institutions, calling the law “a lazy man’s spray gun approach at financial reform.”

One part of the solution, according to McDonald, is populating government agencies with proven risk takers, who have practical knowledge of financial systems. “Bringing real-world players and risk takers into our regulatory system will go a long way to protecting capitalism from its ever growing threat,” he says.

To do so, the government will need to use incentives to entice talent to Washington from Wall Street. He cites the example of Hank Paulson, who, upon becoming Treasury secretary, was able to defer capital gains taxes on Goldman Sachs assets that he sold to avoid a conflict of interests. According to McDonald, expanding the “Paulson Tax Treat” to other government branches would permit a “military-style draft, taking some of Wall Street’s best and brightest into new roles at the SEC, FDIC, CFTC, DOJ, FBI and New York Fed.”

Of course the flip side is that many of these leaders helped to create the problems in the first place and conveniently lost their zeal for free market Darwinism when faced with insolvency. And it is many of these “smartest guys in the room” that have fought reform and have helped water them down to the current weakened state that Mr. McDonald highlights.

One thing McDonald pointed out can’t be denied or ignored, that is four years after the collapse of Lehman the concentration of assets in “too big to fail” institutions has grown larger, which should concern us all.